QUALIPORT
Statistics Of A Monopoly

By Maynard Paton (TMFMayn)
May 24, 2005

The London Stock Exchange (LSE: LSE) has been a drag on the Qualiport's performance in 2005.

At start of the year, the shares stood at 582p in the expectation Deutsche Boerse (owner of the Frankfurt exchange) and Euronext (owner of the Paris, Amsterdam, Brussels and Lisbon exchanges) would enter a bidding war to buy their London counterpart.

However, Deutsche Boerse has since withdrawn from bid negotiations and Euronext's approach is now subject to a protracted competition inquiry. The LSE's shares have since slipped to 477.5p and the Qualiport as a whole is currently 10% down on the year.

No matter. The Qualiport continues to invest for long term and recent results emphasise why the LSE -- essentially a domestic monopoly -- remains a buy and hold favourite. (More details about the operational strengths of the LSE can be found here, here, here and here.)

And let's not forget the Qualiport is still up over 40% on its original three purchases of the LSE!

Five-year record

The table below summarises the LSE's five-year financial record:

Year to March 31st	2001	2002	2003	2004	2005
Turnover (£m)	188.4	206.6	225.9	237.1	244.4
Operating profit (£m)	58.7	70.5	81.7	83.2	82.0
Exceptional items (£m)	(18.9)	(3.6)	(11.6)	-	0.4
Pre-tax profit (£m)	30.4	75.2	79.6	89.7	91.1
Earnings per share* (p)	15.2	18.3	20.9	21.3	23.5
Dividend per share (p)	3.2	3.6	4.3	4.8	7.0

(*Before exceptional items. All figures adjusted for goodwill.)

Last week's annual results revealed a solid if somewhat pedestrian performance. During the year ending March 2005, the LSE's turnover inched 3% higher to £244m while operating profits fell 1% to £82m. Operating margins though remain a wonderful 34%.

Among the LSE's three divisions, Issuer Services was the main disappointer. Turnover here decreased by 9% to £35m following reductions in annual fee tariffs (requested by the Office of Fair Trading last year).

Elsewhere, Broker Services continued its good run of form. Sales improved 6% to £100m following a 15% lift to both the volume of equity bargains and their total value (to 68m and £4,700b respectively).

(Something of interest no doubt to all investors is that the LSE receives an average of £1.50 for every transaction made through its SETS order book.)

However, Information Services did the best of all. Turnover jumped 9% to £110m following a 6% upturn in the number of terminals taking the LSE's market data (the first improvement in terminal numbers for over three years!) and initiatives such as the SEDOL Masterfile.

The figures for 2004/5 also heralded a return of the exceptional item -- a familiar feature of the LSE's books in years gone by. This time the entries related to a £7.2m profit from the sale of the LSE's old Exchange Tower building and a massive £6.8m of fees paid to City advisers involved in the takeover negotiations!

Cash flow and balance sheet

Year to March 31st	2001	2002	2003	2004	2005
Operating profit (£m)	58.7	70.5	81.7	83.2	82.0
Change in working capital (£m)	(4.5)	(4.0)	(20.8)	1.1	(6.2)
Depreciation (£m)	19.9	17.5	19.0	21.9	30.9
Capital expenditure (£m)	(22.7)	(15.8)	(27.4)	(52.0)	(8.5)

Working capital was again minimal in 2004/5, while the first instalment of the proceeds following the sale of the Tower lowered net capital expenditure considerably.

Notably the depreciation charge rose substantially during the year, though the exact reasons behind the increase were not made clear in the LSE's preliminary statement. Given the past relationship between depreciation and capital expenditure though, it did seem a higher charge was needed. Excluding the Tower windfall and cash spent on kitting out the LSE's new City offices, total capital expenditure in 2004/5 came in under the year's depreciation change -- at £26m. 

One accounting practice worth bearing in mind with the LSE's balance sheet is that certain software expenditure is capitalised as a fixed asset and not charged against profits. Considerable expense in this area can be expected in the next few years, as the LSE embarks on the remaining stages of its 'Technology Roadmap', a venture that should cut ongoing IT costs by 20% by 2007/08. As at March 2004, software had an asset value of £35m.

Something that needs no bookkeeping clarification is the LSE's cash hoard. Last year's £163m special dividend was the main reason why net funds fell from £223m to £121m (or 48p per share). With £33m due as the final instalment from the Tower sale at the end of 2005, plus £5m due to be paid in 2006 as the final consideration for a derivatives operation purchased last year, net cash is effectively £149m (or 59p per share). The annual cash-flow performance allowed ordinary dividend payments to be lifted 26% to £18m.

Thankfully, the LSE does not have an onerous pension deficit. At the end of March 2005, the pre-tax shortfall under FRS 17 stood at £19m, equivalent to just 7p per share. The group made an additional £3m contribution in the year just gone and, with annual pre-tax profits running at £90m, the deficit should not hinder progress in the years ahead. Consistent with previous statements (though not with its business!), the LSE intends to move its retirement scheme entirely into bonds over the longer term.

Valuation and summary

The year to March 2005 saw the LSE generate approximately 22.8p per share of operational free cash. Adjust for the cash pile and, at 477.5p, the shares presently offer a historic free cash flow yield of 5.5%. Demanding 7.5% therefore requires an entry price of 362p.

Obviously Euronext's lingering interest in buying the LSE continues to prop up the share price. An inquiry is currently underway by the Competition Commission to establish whether the bids from Deutsche Boerse (now withdrawn) and Euronext 'may be expected to result in a substantial lessening of competition' within the UK equity trading market. A provisional decision will be made in July with a full and final report due in September.

Submissions sent to the Competition Commission support the view that the LSE is a business 'franchise'. Although some of the third parties submitting their thoughts no doubt have 'vested interests' (and would prefer to see a takeover scuppered), a term some used to describe the LSE was 'commercial monopoly'. The submissions from Deutsche Boerse and Eurnoext were particularly interesting, not least because both exchanges confirmed neither was likely to enter the UK market directly because of the inherent strengths enjoyed by the London exchange.

Something else of interest is the recent merger between Archipelago (Nasdaq: AX), a US electronic trading platform, and the New York Stock Exchange. The deal will see the NYSE transform into a public company and perhaps one day become a suitor for the LSE itself (assuming Euronext's approach comes to nothing). Whatever, the cost savings that can be produced from two major exchanges becoming are huge and justify an LSE takeout price of at least 600p a share. According to recent press reports, the LSE itself has indicated a fair takeover price to be 715p per share.

So until further news from the Competition inquiry and/or Euronext emerges, existing shareholders can comfort themselves with the following LSE statistics, all of which should continue to grow in the decades ahead:

Year	Value of equity trades (£m)	Number of equity trades	Total London market value (£m)
1963	3,479	3,417,395	32,204
1974	12.616	3,935,431	17,466
1984	69.404	4,498,172	205,605
1994	606,003	9,386,305	774,557
2004	2,316,195	53,907,459	1,492,459

More: LSE Competition Commission Inquiry | The LSE Is Worth 600p A Share

Maynard owns shares in London Stock Exchange.

Portfolio value

Holding	Number of shares	Closing price 23/05/05 (p)	Value (£)
Associated British Ports	681	480.25	3,270.50
Emap	372	765	2,845.80
Halma	1,920	149	2,860.80
Johnston Press	1,608	488	7,847.04
London Stock Exchange	2,018	477.5	9,635.95
Cash			345.54
Total			26,805.63